Algorithmic Trading

Session 10
Performance Analysis I
Performance Measurement

Oliver Steinki, CFA, FRM

Outline

 Introduction
 Arithmetic vs. Geometric Mean
 Why Dollars are More Important Than Percentages
 Traditional Performance Measures
 Time Weighted vs. Money Weighted Rates of Return
 Performance Measurement with Cash Deposits and Withdrawals
 Summary and Questions
 Sources

Contact Details: [email protected] or +41 76 228 2794 2

Introduction
Where Do We Stand in the Algo Prop Trading Framework?
SIGNAL GENERATION  As we have seen, algorithmic proprietary trading strategies can be broken down into
three subsequent steps: Signal Generation, Trade Implementation and Performance
DECIDE WHEN AND Analysis
HOW TO TRADE
 Performance Analysis is conducted after the trade has been closed and used in a
backtesting context to judge whether the strategy is successful or not. In general, we can
judge the performance according to five different metrics: return, risk, efficiency, trade
frequency and leverage
TRADE
IMPLEMENTATION  Sessions 10 -12 deal with the question of analyzing performance
SIZE AND EXECUTE – Today’s Session 10: Performance Measurement
ORDERS, INCL. EXIT
– Session 11 & 12: Performance Analysis

PERFORMANCE
ANALYSIS

RETURN, RISK AND

EFFICIENCY RATIOS

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Introduction
Performance Measurement
 Performance measurement is a critical aspect of portfolio management
 Proper performance measurement should involve a recognition of both the return and the riskiness of the
investment
 When two investments’ returns are compared, their relative risk must also be considered
 People maximize expected utility:
– A positive function of expected return
– A negative function of the return variance

4
Introduction
A Historical Guideline
 The 1968 Bank Administration Institute’s Measuring the Investment Performance of Pension Funds concluded:
– Performance of a fund should be measured by computing the actual rates of return on a fund’s assets
– These rates of return should be based on the market value of the fund’s assets
– Complete evaluation of the manager’s performance must include examining a measure of the degree of risk
taken in the fund
– Circumstances under which fund managers must operate vary so greatly that indiscriminate comparisons
among funds might reflect differences in these circumstances rather than in the ability of managers

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Key Points of Performance Measurement
Arithmetic vs. Geometric Mean
 The arithmetic mean is not a useful statistic in evaluating growth. It might give misleading information as a 50
percent decline in one period followed by a 50 percent increase in the next period does not produce an average
return of zero
 Consider the following example from the assigned reading. 44 Wall Street and Mutual Shares both had good
returns over the 1975 to 1988 period:

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Key Points of Performance Measurement
Review: Why the Arithmetic Mean Is Misleading
 The proper measure of average investment return over time is the geometric mean:
1/ n
 n 
GM   Ri   1
 i 1 
where Ri  the return relative in period i

 The geometric means in the preceding example are:

– 44 Wall Street: 7.9 percent
– Mutual Shares: 22.7 percent
 The geometric mean correctly identifies Mutual Shares as the better investment over the 1975 to 1988 period

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Key Points of Performance Measurement
Dollars Are More Important Than Percentages
 Measuring dollar values clearly shows that Mutual shares significantly outperformed 44 Wall Street:

Mutual Fund Performance

$200,000.00
$180,000.00
$160,000.00
$140,000.00
Ending Value ($)

$120,000.00
$100,000.00
$80,000.00
$60,000.00
$40,000.00
$20,000.00
$-

Year
44 Wall Street Mutual Shares

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Key Points of Performance Measurement
Dollars Are More Important Than Percentages
 Assume two funds managed by the same portfolio manager:
 Fund A has $40 million in investments and earned 12 percent last period
 Fund B has $250,000 in investments and earned 44 percent last period
 The correct way to determine the return of both funds combined is to weigh the funds’ returns by the dollar
amounts:
 $40, 000, 000   $250, 000 
 $40, 250, 000 12%    $40, 250, 000  44%   12.10%
   

 In fact, 99.38 percent of the $40.25 million managed by this person earned 12 percent. Only 0.62 percent
earned the higher rate

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Traditional Performance Measures
Sharpe and Treynor Measures
 The Sharpe and Treynor Measures are calculated as follows:

R  Rf
Sharpe measure 

R  Rf
Treynor measure 

where R  average return
R f  risk-free rate
  standard deviation of returns
  beta

 The Sharpe measure evaluates return relative to total risk. Hence, it is appropriate for a well-diversified
portfolio, but not for individual securities
 The Treynor measure evaluates the return relative to beta, a measure of systematic risk. Hence, it ignores any
unsystematic risk and is therefore also not appropriate for individual securities

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Traditional Performance Measures
Jensen Measure
 The Jensen measure stems directly from the CAPM:

Rit  R ft     i  Rmt  R ft 

 The constant term should be zero. Securities with a beta of zero should have an excess return of zero according to
classical finance theory
 According to the Jensen measure, if a portfolio manager is better-than-average, the alpha of the portfolio will be
positive
 However, the use of Treynor and Jensen Measure relies on measuring the market return and CAPM
 Difficult to identify and measure the return of the market portfolio
 Evidence continues to accumulate that may ultimately displace the CAPM, but Arbitrage pricing model,
multi-factor CAPMs, inflation-adjusted CAPM could help

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Traditional Performance Measures
Fama’s Return Decomposition
 “Fama’s return decomposition” can be used to assess why an investment performed better or worse than expected:
 The return the investor chose to take
 The added return the manager chose to seek
 The return from the manager’s good selection of securities
 Diversification is the difference between the return corresponding to the beta implied by the total risk of the
portfolio and the return corresponding to its actual beta
 Net selectivity measures the portion of the return from
selectivity in excess of that provided by the
“diversification” component

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Dollar Weighted vs. Time Weighted Rates of Returns
Overview
 The dollar-weighted rate of return is analogous to the internal rate of return in corporate finance. It is the
rate of return that makes the present value of a series of cash flows equal to the cost of the investment

C1 C2 C3
cost   
(1  R) (1  R) 2 (1  R)3
 The time-weighted rate of return measures the compound growth rate of an investment. It eliminates the
effect of cash inflows and outflows by computing a return for each period and linking them (like the geometric
mean return):

time - weighted return  (1  R1 )(1  R2 )(1  R3 )(1  R4 )  1

 The time-weighted rate of return and the dollar-weighted rate of return will be equal if there are no inflows or
outflows from the portfolio

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Performance Measurement with Cash Deposits and Withdrawals
Overview
 The owner of a fund often takes periodic distributions from the portfolio, and may occasionally add to it
 The established way to calculate portfolio performance in this situation is via a time-weighted rate of return:
– Daily valuation method
– Modified Bank Administration Institute (BAI) method
 The daily valuation method:
– Calculates the exact time-weighted rate of return
– Is cumbersome because it requires determining a value for the portfolio each time any cash flow occurs. This
might be interest, dividends, or additions to or withdrawals

 The modified BAI method:

– Approximates the internal rate of return for the investment over the period in question
– Can be complicated with a large portfolio that might conceivably have a cash flow every day

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Performance Measurement with Cash Deposits and Withdrawals
Daily Valuation Method
 The daily valuation methods solves for R:
n
Rdaily   Si  1
i 1

MVEi
where S 
MVBi

 MVEi = market value of the portfolio at the end of period i before any cash flows in period i but including accrued
income for the period
 MVBi = market value of the portfolio at the beginning of period i including any cash flows at the end of the previous
subperiod and including accrued income

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Performance Measurement with Cash Deposits and Withdrawals
BAI method
 The BAI methods solves for R:
n
MVE   Fi (1  R) wi
i 1

where F  the sum of the cash flows during the period

MVE  market value at the end of the period,
including accrued income
F0  market value at the start of the period
CD  Di
wi 
CD
CD  total number of days in the period
Di  number of days since the beginning of the period
in which the cash flow occurred

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Performance Measurement with Cash Deposits and Withdrawals
Example
 An investor has an account with a mutual fund and “dollar cost averages” by putting $100 per month into the fund
 The following table shows the activity and results over a seven-month period

Date Description $ Amount Price Shares Total Shares Value

January 1 balance $7.00 1,080.011 $7,560.08
forward
January 3 purchase 100 $7.00 14.286 1,094.297 $7,660.08
February 1 purchase 100 $7.91 12.642 1,106.939 $8,755.89
March 1 purchase 100 $7.84 12.755 1,119.694 $8,778.40
March 23 liquidation 5,000 $8.13 -615.006 504.688 $4,103.11
April 3 purchase 100 $8.34 11.900 516.678 $4,309.09
May 1 purchase 100 $9.00 11.111 527.789 $4,750.10
June 1 purchase 100 $9.74 10.267 538.056 $5,240.67
July 3 purchase 100 $9.24 10.823 548.879 $5,071.64
August 1 purchase 100 $9.84 10.163 559.042 $5,500.97

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Performance Measurement with Cash Deposits and Withdrawals
Example: Daily Valuation Method
 The daily valuation method returns a time-weighted return of 40.6 percent over the seven-month period

Ending
Date Sub Period MVB Cash Flow Value MVE MVE/MVB
January 1 $7,560.08

January 3 1 $7,560.08 100 $7,660.08 $7,560.08 1.00

February 1 2 $7,660.08 100 $8,755.89 $8,655.89 1.13
March 1 3 $8,755.89 100 $8,778.40 $8,678.40 0.991
March 23 4 $8,778.40 5,000 $4,103.11 $9,103.11 1.037
April 3 5 $4,103.11 100 $4,309.09 $4,209.09 1.026
May 1 6 $4,309.09 100 $4,750.10 $4,650.10 1.079
June 1 7 $4,750.10 100 $5,240.67 $5,140.67 1.082
July 3 8 $5,240.67 100 $5,071.64 $4,971.64 0.949
August 1 9 $5,071.64 100 $5,500.97 $5,400.97 1.065
Product of MVE/MVB values = 1.406;  R = 40.6%

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Performance Measurement with Cash Deposits and Withdrawals
Example: BAI Method
 The BAI method returns a time-weighted return of 42.1 percent over the seven-month period. However, it
requires a function like solver in Excel
Weight
Date Day (214-days)/214 Cash Flow (1.421) weight x cashflow
January 1 0 1.000
January 3 2 0.9907 $7,560.06 $10,741.36
February 1 31 0.8551 $100 $141.62
March 1 60 0.7196 $100 $135.03
March 23 83 0.6121 $5,000 $128.75
April 3 94 0.5607 $100 ($6,199.20)
May 1 123 0.4252 $100 $121.77
June 1 153 0.2850 $100 $116.17
July 3 185 0.1355 $100 $104.87
August 1 214 0.0000 $100 $100
Total $5,500.84

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Summary and Questions

 Performance evaluation is a critical part of the portfolio management process. The central issue is coupling a
measure of risk with the return of a portfolio.The measurement of risk is often neglected
 Average returns over time should be measured using a geometric growth rate. The arithmetic mean gives
misleading results and should not be used to compare competing investment funds or strategies
 The Sharpe and Treynor measures are the two leading classical performance indicators. Their calculations are
similar, except that the Sharpe measure uses the standard deviation of returns as a risk measure whereas the Treynor
measure uses beta. Jensen’s measure is not that common anymore, although his definition of alpha is still used for
outperformance
 When a portfolio has frequent cash deposits and withdrawals, it is best to calculate performance via a time-
weighted rate of return

 Questions?

Contact Details: [email protected] or +41 76 228 2794 20

Sources

 Portfolio Construction, Management, and Protection by Robert A. Strong

Contact Details: [email protected] or +41 76 228 2794 21